How Does Interest Work on Student Loans?

Student loan interest can have a major impact on the amount of debt you ultimately repay. Interest on student loans is generally calculated on a daily basis, usually starting as soon as funds are disbursed. At certain points, that accrued but unpaid interest may be capitalized, meaning it gets added to your loan's principal balance.

To effectively repay your student loans rather than getting bogged down in a prolonged cycle of interest accrual, it helps to have a sense of how student loan interest works and how it's calculated. That way, you'll know how to minimize it.

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What is student loan interest?

Student loan interest is the cost of borrowing money. It’s the amount your lender charges you on top of the amount you originally borrowed.

Your interest rate has the biggest impact on how much you pay to borrow. Federal student loans have fixed interest rates, which stay the same for the life of the loan. Private student loans may have fixed or variable rates. Variable rates can change over time, which means your borrowing costs can also increase or decrease.

How is student loan interest calculated?

How much interest you pay depends mainly on your interest rate, principal balance, and how long you take to repay the loan. Most student loans accrue interest daily, even though you typically make one payment each month. That means a small amount of interest adds up each day based on your remaining balance and interest rate. 

When your monthly payment is due, it generally covers the interest that has accrued since your last payment first. The rest goes toward reducing your principal balance. As you pay down your principal, less interest accrues each day, which can allow more of your future payments to go toward principal.

Daily interest calculation example

You can estimate how much interest accrues each day using this formula:

(Principal balance × interest rate) ÷ 365.25 = daily interest

For example, if you have a $20,000 student loan with a 7% interest rate:

$20,000 × 0.07 ÷ 365.25 = $3.83 per day

That means about $3.83 in interest accrues each day, or roughly $115 over 30 days. As your principal balance decreases, your daily interest charge also decreases.

When does interest start accruing? 

For most federal and private student loans, interest starts accruing when the loan is disbursed, even if you aren’t required to make payments while you’re in school or during your grace period. 

Federal Direct Subsidized Loans are the exception. These loans are available to undergraduate students with financial need, and the government covers the interest while you’re enrolled at least half time and during your six-month grace period after leaving school. Interest starts accruing after the grace period ends.

What happens if you don't pay student loan interest?

If you don’t pay the interest that accrues on your student loans, it may later be capitalized, depending on your loan type and repayment situation. That means it’s added to your principal balance, and future interest accrues on the larger balance, which can significantly increase the total cost of your loan.

For example, if interest accrues on a private student loan or unsubsidized federal loan while you’re in school or during a deferment, you may not have to make payments right away. But that unpaid interest can be added to your principal when the deferment ends.

“Depending on the interest rate, this means that the loan balance will be 20% to 30% higher when the loan enters repayment,” says Mark Kantrowitz, author of “How To Appeal for More College Financial Aid.”

Capitalization can also occur if you leave the federal Income-Based Repayment (IBR) Plan or consolidate federal loans into a Direct Consolidation Loan. 

See Also: 5 Reasons Your Total Student Loan Balance Increases

How to reduce the amount of interest you pay

If you're worried about just how much interest charges can drive up the amount you ultimately repay on your loan, know that there are ways to minimize them. These include:

• Make interest payments while in school: With the exception of subsidized federal loans, interest generally starts to accrue on student loans as soon as they are disbursed — even while you're still in school. By making interest-only payments during that time, you can cut down on the amount of interest that gets added to your loan, potentially saving you significantly in the long run.
• Pay extra toward the principal to lower total interest costs: Another way to save on interest is to put extra money toward paying down your loan's principal. This way, your loan's interest charges are lower since they're calculated on a lower principal balance.
• Refinance for a lower interest rate: You can also pay less in interest if you secure a lower interest rate than you currently have. If your credit score and other financial factors have improved since you first took out your loan, you may be able to land a more competitive rate through student loan refinancing.
• Shorten your repayment timeline: Another simple way to reduce the amount of interest you pay is to opt for a shorter repayment term. “If you look at amortization tables for how much you'd pay under a 20-year versus a 5- or 10-year loan, a longer-term loan has a lot more interest built into it,” says Barfield. “A 25-year plan will usually cost you double what you borrowed to get that degree,” he notes, whereas “with a 10-year standard payment plan, interest is usually half of what was borrowed in total payments.”